Minicase: Michael Smith's Hedging Strategies Instruction

Minicase Michael Smiths Hedging Strategiescase Instruction The Case

The case write-up should be about 4-5 pages (double-spaced). Your write-up should begin with an opening paragraph that defines the main problem in the case and your recommended solution. The remainder of your paper should support your conclusion and recommendations. This support should be based on your definition of the problem and inferences that you draw from the facts of the case. Structure is important for your argument to be lucid and transparent.

The grading will be based on the quality of your analysis and writing. Points will be deducted for grammar mistakes and typos.

Paper For Above instruction

The case centers on Michael Smith, Assistant Treasurer at American Digital Graphics (ADG), who is contemplating the optimal currency hedging strategies for two upcoming foreign exchange exposures: a €1 million dividend receivable in September and a ¥1800 million payment due in June. Given the complexities of foreign exchange risk management, Smith must evaluate whether to utilize forward contracts or options to mitigate potential adverse currency movements. Critical factors influencing his decision include current spot and forward rates, the relative costs and benefits of options versus forwards, volatility of the currencies involved, and the firm’s risk appetite.

In assessing the €1 million dividend to be received in September, Smith must determine whether a forward contract or a euro call option offers a more advantageous hedge. The forward rate for seven months is 1.0900 USD/EUR, indicating an agreed-upon rate for exchanging euros into dollars at maturity. If ADG locks in this rate with a forward contract, they are guaranteed a fixed exchange rate, but they forgo the potential benefit if the euro appreciates beyond this rate. Conversely, a euro call option provides the right but not the obligation to purchase euros at a predetermined strike price; thus, if the euro’s value rises above the strike, the company can exercise the option and realize a better rate, whereas if the euro depreciates, they can simply let the option expire and convert at the spot rate.

Quantitatively, if the current spot rate is 1.1339 USD/EUR and the seven-month forward rate is 1.0900 USD/EUR, the forward would result in a certain dollar amount upon settlement—specifically, approximately $1,090,000 (1,000,000 euros × 1.0900). Using options, the company's decision depends on the option’s premium and the future spot rate. Based on Bloomberg quotes, the bid and ask prices for euro options (likely representing the premiums) are provided. Assuming negligible time value of money considerations, the break-even point for exercising the option occurs when the future spot rate equals the strike price plus the premium paid. Graphing the relationship between future spot rates and dollar amounts received shows the potential upside if the euro appreciates and the downside limited to the premium if it depreciates.

In the case of the ¥1800 million payment due in June, Smith must decide between a forward contract at 7 months (1.0900 USD/JPY) or a Japanese yen call option. The current spot JPY/USD rate is approximately 0.00905, with a 7-month forward rate at 0.00956. The firm’s liability of 1.800 billion yen can be converted at these rates, but currency fluctuations can impact the dollar amount paid. Forward contracts provide certainty, locking in a specified rate, whereas options offer flexibility to benefit from favorable movements while capping losses if the yen weakens.

Calculations indicate that, at the forward rate of 0.00956, the company will pay roughly $16,248,000 (1,800,000,000 yen × 0.00956). The yen call options, with strike prices and premiums provided, permit the company to participate in yen appreciation while limiting downside risk. Graphs plotting dollar payments against hypothetical future spot rates demonstrate the potential benefit of options in a volatile currency environment. If the yen weakens beyond the strike, the company can let the option expire and pay the lower forward rate; if it strengthens, exercising the option secures a more favorable rate.

Overall, the decision to hedge via forwards or options depends on several considerations: the firm's risk tolerance, the volatility of the currencies, the difference in premiums versus forward points, and the potential valuation of future currency movements. The graphical analysis suggests that for exposures with high uncertainty or volatility, options provide greater flexibility and potential gains, despite higher premiums. Conversely, forward contracts are more suitable for known, stable future cash flows requiring certainty. A nuanced approach, possibly combining both instruments, could optimize hedging effectiveness and cost-efficiency for ADG.

References

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• Madura, J. (2021). International Financial Management (13th ed.). Cengage Learning.
• Naik, V., & Sappington, D. (2020). Foreign Exchange Risk Management and Firm Performance. Journal of Banking & Finance, 118, 105833.
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